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Issue 43/ 19 Sept 2012


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  1. What motivates price movements in commodity markets? Nigel Tree
  2. The impact of alternative paths of fiscal consolidation on output and employment in the UK by Nitika Bagaria, Dawn Holland, Jonathan Portes, John Van Reenen.


1) What motivates price movements in commodity markets? Nigel Tree

Some of us can still remember the oil crisis of the mid 1970s when the Organisation of Arab Petroleum Exporting Countries (OAPEC) put an embargo on the supply of oil, as a result of US support for Israel. Between October 1973, when the embargo started, and the following year, the price of oil quadrupled.

We have come to expect that major price movements in commodity markets are generally caused, not only by export bans, but by adverse weather conditions where crops or supply lines are severely damaged. In other words, it is changes in the ‘real economy’ which affects prices.

However, a report has just been published by the United Nations Conference on Trade and Development (UNCTAD), entitled: “Don’t blame the physical markets”. The Report accepts that real world factors do cause the odd supply shock in commodity markets which can cause prices to spike, especially with the presence of inelastic demand. But says that: “with the volumes of exchange-traded derivatives on commodity markets now being 20 to 30 times larger than physical production, the influence of financial markets has systematically transformed these real markets into financial markets.”

It is argued that commodity prices across all major categories are clearly moving in tandem, a trend which excludes explanations based on shocks in single markets. A summary of the Report is given below.


The impact of financial investors in commodity markets
Investment in commodities or their derivatives has expanded in value from less than $10bn at the end of the last century to $450bn in April 2011. The volumes of exchange-traded derivatives on commodity markets are now 20 to 30 times greater than physical production. Financial investors only accounted for less than 25% of all market participants in the 1990s, but now represent more than 85%.

These financial traders do not trade on the basis of supply and demand relationships in any particular commodity market, but in response to movements in other financial markets. They tend to move in the same direction at the same time – what the report calls ‘herding’.

Thus it can be seen that commodity markets and financial markets are moving in parallel. Investors in commodity markets are being influenced by political announcements and changes in the world economy, rather than by fundamentals.

The Report highlights a situation earlier this year. In early 2012 commodity investments briefly rebounded, but then in the second quarter turned negative. According to Barclays Capital (2012), investors withdrew $8.2bn from commodity investments in May 2012, in what was described as “something approaching a stampede.” It would appear that, for example, the changes in oil prices have coincided with those on the European stock markets which in turn have been influenced by political decisions and rumours in the eurozone.


Evidence for the link between commodity markets and financial markets
Charts 1 and 2 below show changes in prices of the Euro Stoxx 600, the West Texas Intermediate (WTI) oil price – a benchmark in the US – and the Standard and Poor’s Goldman Sachs Commodity Index (SPGSCI) which is a broad commodity index. The situations in 2002 and 2012 are then compared.

Chart 1

10 years ago



Chart 2

... and now

Chart 2


There were similarities in both years as far as real world shocks were concerned, but the performance of the three indices are very different. The Report points out that ten years ago each market had its own dynamics, but in 2012 they are moving in nearly perfect tandem. An example is given showing the influence of financial investors on commodity markets. In late June 2012, following an agreement on the recapitalisation of banks in the eurozone, the price of Brent oil rose 7% in one day and the price of WTI rose by 9%. This ‘spike’ can be clearly seen in Chart 2.


The Report points out quite forcefully that it is eurozone events and market sentiment which determine commodity prices, regardless of trade logistics issues, war, drought and other ongoing supply shocks.

It concludes: “Due to the increased participation of financial players in those markets, the nature of information that drives commodity price formation has changed. Contrary to the assumptions of the efficient market hypothesis, the majority of market participants do not base their trading decisions purely and independently on the fundamentals of supply and demand: they also consider aspects related to other markets or to portfolio diversification to be important. This introduces spurious price signals into the market.

Moreover, in a situation of widespread herding in financial markets, the assumption of an atomistic market, in which participants trade individually and independently of each other on the basis of their own interpretation of fundamentals, no longer holds. The price discovery market mechanism is seriously distorted. Prices can move far from levels justified by the fundamentals for extended periods.

Because of these distortions, commodity prices in financialized markets do not provide correct signals about the relative scarcity of commodities. This impairs the allocation of resources and has negative effects on the real economy. To restore the proper functioning of commodity markets, swift political action is required on a global scale.”

To see the full article and its policy recommendations click here.


2) The impact of alternative paths of fiscal consolidation on output and employment in the UK by Nitika Bagaria, Dawn Holland, Jonathan Portes, John Van Reenen.

While most economists agree that the UK and other countries need to cut back to ensure the sustainability of their public finances, the debate rages over when and by how much. This column argues that the timing matters – starting too early, before the economy has recovered, will have substantial economic costs.

In 2009-2010, the UK's budget deficit was about 11% of GDP (see here); there was no dispute among economists that a credible plan for fiscal consolidation was required. The discussion turned on the timing, given the fact that short-term interest rates are effectively at zero, output is substantially below capacity, and unemployment well above most estimates of the natural rate of unemployment.

  • Many argued that consolidation should be delayed until recovery was clearly established.
  • Others argued that early action was required to prevent large deficits leading to higher interest rates.

However, few on either side attempted to quantify the costs and benefits of delay. Our new research attempts to do just that (Bagaria et al. 2012).

In standard macroeconomic models of the sort used by most central banks and finance ministries, the effects of fiscal policy are often small and short-lived. This is for three reasons:

  • With an inflation target, the central banks will largely offset the impact on demand of changes to fiscal policy;
  • Fiscal multipliers don't vary much, if at all, across the cycle, so it doesn't really matter much when consolidation is undertaken
  • The strong equilibrium-reverting properties of such models means that output tends to revert to trend in any event.

But these assumptions are all questionable (see, for example, DeLong and Summers 2012; and Auerbach and Gorodnichenko 2012).

  • First, interest rates, both short and long term, are currently extraordinarily low, despite very high deficits.

The response of monetary policy to fiscal policy may be different if consolidation is undertaken at a time when interest rates are close to the zero lower bound.

  • Second, in normal times, the ability to borrow enables households and firms to smooth consumption and investment over time, reducing the impact of fiscal policy.

But, given the impact of the financial crisis on the banking system, some households and firms may be unable to borrow under current conditions – they may be ‘credit constrained’ (Barrell et al. 2012).

  • Third, protracted high levels of unemployment may have an impact on the supply side of the economy over the medium term.

The long-term unemployed are less likely to look for, or to get, jobs, and may suffer permanent damage to skills and motivation. This may reduce the efficiency of the labour market, damaging output and employment; the existence of these hysteresis effects in the UK labour market are well established, but rarely incorporated into macroeconomic forecasting (see, for example, Nickell 1987 and Manning 1993).

In Bagaria et al. (2012), we use NIESR's macroeconomic model, NiGEM, to model all three of these effects. We assume that monetary policy would not in practice have responded to changes in fiscal policy, with interest rates at the zero lower bound and demand depressed; we assume that a higher proportion than normal of consumers and firms are credit constrained; and we incorporate into our wage determination equation the impact of current elevated levels of long-term unemployment, using the transition probabilities estimated by Elsby and Smith (2010). We do not, however, incorporate the even longer-lasting hysteresis effects that would occur if long-term unemployment led to permanent withdrawal from the labour force; it is too early to tell if this is happening in the UK in this recession.

We contrast three scenarios:

  • The consolidation plan implemented by the current British government;
  • The same plan, but with implementation delayed for three years; and
  • No consolidation at all.

As expected, the modelling does indeed show that doing nothing was not an option; our ‘no fiscal consolidation’ scenario leads to unsustainable debt ratios . So some pain is inevitable; under both our ‘immediate consolidation’ scenario, and the ‘delayed consolidation’, the necessary increases in taxes and reductions in spending reduce growth and increase unemployment.

But our estimates indicate that the impact would have been substantially less, and less long-lasting, if consolidation had been delayed until more normal times. The cumulative loss of output over the period 2011-2021 amounts to about £239 billion in 2010 prices, or about 16% of 2010 GDP. And unemployment is considerably higher for longer – still 1 percentage point higher even in 2019, because the impact of consolidation lasts for 2-4 years longer if tightening comes when the economy is depressed. So early tightening has real, and large, costs.

Table 1. GDP in £billion, 2010 prices under two scenarios

Chart 3

Source: NiGEM simulations

We assume that delaying fiscal tightening has no impact on long-term interest rates. This is consistent with recent experience, both in the UK and in other advanced countries with monetary independence (IMF 2012), who suggest that there is "little evidence" that slowing consolidation would trigger an adverse market reaction . As pointed out in Portes (2012) and IMF (2012), "long term interest rates in the UK and US have also correlated positively with equity price movements, indicating that bond yields have been driven more by growth expectations than fears of a sovereign crisis."

It is important to say that these are scenarios, not forecasts; our modelling could be overestimating or indeed underestimating the impact of delay. The choice of 2014 as a time when the economy would have returned to normal is arbitrary, and of course in reality wider global economic developments could well have changed that in any case. But they are a useful illustration of why, and how much, macroeconomic policy judgements matter.

The good news is that, in the long run, in our model at least, it does all wash out; whatever the path of consolidation, the economy eventually returns to long-run equilibrium. What this analysis shows is that the economic pain resulting from fiscal consolidation could not have been avoided, but could have been substantially reduced. The standard policy prescription – to delay deficit reduction until after recovery is clearly under way and the output shortfall significantly reduced – remains valid.


Auerbach, Alan and Yuriy Gorodnichenko, (2012), "Fiscal multipliers in recession and expansion”, American Economic Journal; Economic Policy, 4(2):1-27

Bagaria, Nitika, Dawn Holland and John Van Reenen (2012), "Fiscal Consolidation in a Depression", National Institute Economic Review 221.

Barrell, Ray, Dawn Holland and Ian Hurst, (2012), "Fiscal consolidation Part 2: fiscal multipliers and fiscal consolidations", OECD Economics Department Working Paper No. 933

Elsby, Michael and Jennifer Smith (2010), "The great recession in the UK labour market: a transatlantic perspective", National Institute Economic Review 214.

DeLong, Brad, and Lawrence Summers, "Fiscal policy in a depressed economy", presented at the Brookings Panel on Economic Activity, March 2012.

Machin, Steve and Alan Manning (1999), "The causes and consequences of long term unemployment in Europe", Handbook of Labour Economics, Vol. 3.

Manning, Alan (1993), "Wage bargaining and the Phillips curve: the identification and specification of aggregate wage equations", Economic Journal, 103(416):98-118.

Nickell, Steve (1987), "Why is wage inflation in Britain so high?", Oxford Bulletin of Economics and Statistics, 49(1):103-128.



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